Tatton’s Weekly, 8 August 2014 – Time for a change of strategy

This week it felt like August picked up and continued exactly where July ended – geopolitical events overwhelming the positive macro-economic news front and driving equity markets lower. The one positive to record is that Israel ended its offensive on Gaza and US president Obama agreed to provide air strike support to Iraq to prevent the ISIS’ extremists from further massacres of non-Muslims.

Matters like these were discussed at length this week in preparation and during Tatton’s monthly investment committee meeting. The outcome of this comprehensive review of the medium term economic prospects and anticipated market reflection has resulted in a decision to adjust the fixed income investments of the Tatton portfolios to take account of the anticipated environment ahead. In summary we have come to the conclusion that as a consequence of the past years’ desperate search for yield of so many investors, corporate bonds have now reached a level of overvaluation as we previously experienced with government bonds at the beginning of 2013. The distinct difference between government bonds (gilts) and corporate bonds (investment grade, high yield and junk bonds) is that gilts only carry yield curve risk (that yields will rise and fall), whereas corporate bonds additionally introduce an element of company risk exposure, which is akin to stock market risk. It has become all but consensus that the yield uplift corporate bonds provide in return for the additional company risk is now so low that the combination of the underlying components or government bonds (yield curve) and a smaller proportion of equities (corporate) generate a very similar risk characteristic, but at the moment with a much improved return profile. So while we have avoided government bonds for the past 18 months, we are now reintroducing them to the portfolios. After the gilts value declines of 2013 we now see a much reduced capital loss risk in them over the medium term, while they once again provide their extremely valuable risk counterbalance to stock market investments.

The end result of this will be portfolios within the risk confines of what investors have signed up for, but structured temporarily in a barbell format of government bonds (low risk) and equities (high risk). They will for the time being exclude the corporate bond middle part of the risk-return continuum. The ‘middle’ has become overcrowded by those investors who can for regulatory reasons only invest in fixed interest instruments or are desperate for yield, rather than dividends. In our multi-asset portfolios we are under no such limiting restriction and therefore take the more rational action described. Given we are also optimistic about the general economic outlook and as a result of the medium term return potential of stock markets, we also maintain our relative overweight to equities and underweight to bonds across the portfolios.